In one of your speeches, you talked about cozy relations between analysts and company management. You called it "a web of dysfunctional relationships" in an era of "gamesmanship." What did you mean?

What I meant by that is that the economics of Wall Street has changed dramatically. When fixed commissions were eliminated [in 1975], more and more of Wall Street's profits had to come from investment banking. But what is the very best way to get investment banking business? The language of Wall Street is, "We'll get you coverage." And what kind of coverage does that mean? An overwhelming number of research reports written about investment banking clients are favorable.

And all too often, corporate executives on the other side of the table who are anxious to get favorable coverage, to get hype for stock -- corporate executives who have a tactical feeling for what their stock is selling for, rather than a strategic vision of the future -- will try and embrace a favored analyst, intellectually at least, and say to that analyst, "I will share with you information that will not be made available to anybody else, certainly none of your competitors. You'll have it first." It's not said in those words. But it's a very easy relationship to establish.

The analyst very often is compensated by bringing in investment banking business as much as he is by the quality of his or her analysis. So those relationships between companies, bankers and analysts can become much too incestuous, much too cozy and work against the best interest of the individual investor, who is very often the last person in the cycle for that information.

But there was a time ... I mean, this relationship between the bankers and the analyst goes back a ways. Isn't it exacerbated, made worse, by the coming of individual small retail investors into the marketplace who don't know the language, who can't discount the buy recommendations?

I think these relationships have existed for some time. But the situation grows worse as the number of individual investors coming into the market proliferates. The situation gets worse when a constant upward movement in the market makes investors feel that whatever analysis they receive is absolutely on the money, that they can't lose in this environment. The psychology of investors at a time like this is to believe anything which would justify their acquiring stocks or funds.

And what is most dangerous about this is the confidence of the individual investor is vastly more important at this time in the market cycle -- they are really the most important factor in our markets. For them to lose confidence in the independence of the research that they've been basing their investment decisions on could have serious implications for our market as a whole.

Explain what you mean when you said the retail investor was so important.

A rising market invariably brings with it a proliferation of individuals who believe that they can get into the market at this point in time. In addition, we have more information coming to investors today than ever before, both electronically and in print.

No matter which way you look, there are inducements for investors to buy stocks that are at least comparable to inducements to buy soap and diapers. So what is that individual going to do? He looks at television and he sees an ad which says if you invest in this firm, then you will have an island of your own.

I think that's absolutely trivializing the investing process. It is the kind of advertising which will come back to haunt the firms that put it out. It is characteristic of what has been going on in our markets for the past at least four or five years.

Do any of those inducements stand out in your memory?

The inducements to get rich quick -- the island that can be yours, the luxury home that was presented by another online broker, that's yours -- all of that is playing on the ease with which individuals can execute orders by a few keystrokes on their computers. We have so glamorized the role of the trader that investors believe that they're like the heroes in the movies and the books and the television programs -- [that] they can be the same machismo individual that they've been reading about.

What they don't understand is that the typical investor lacks the resources, the temperament, the expertise that a professional trader has. And a trader's mentality in my judgement works against an individual's best interests. An individual should be much more concerned with value than rumor.

An individual should make his or her investments intellectually, not emotionally; and this advertising is playing to emotions. It's playing to the basest instincts of investors, rather than trying to teach them how to be prudent investors. Being an investor is a professional discipline. It is not something for day traders, where you'd do better to go to the tracks or casino. ...

Are you saying that, with savvy and with discipline and rigor, the individual investor can play on a level playing field?

I think there are some new factors in the markets today, the most important of which is Regulation Fair Disclosure, which mandates that every company, in putting out relevant information about the company, must give it to all parties at the same time.

That means no longer can a company call in the institutional analyst of their choice and give them information about earnings or new technology or adverse developments, and the first that the individual investor hears about it is when the stock has already reacted by 20 percent or 25 percent. Today that would be a violation of the securities law. And that, in my judgement, substantially levels the playing field.

I think more has to be done in that connection. I think more has to be done with professional analysis that has relied more on rumor, innuendo and inside tips than it has upon the hard work and discipline of digging into the financial statements and, really, guts of the company.

So I think the playing field is fairer today, but I think it's got a ways to go. While I was there, the SEC asked the New York Stock Exchange [and] the NASD [National Association of Securities Dealers] to go through a rulemaking proceeding to see to it that the conflicts enjoyed by analysts were cleared up ... to create specific rules to free analysts from the sort of taint that compromises their judgement.

Where is this? This goes back nearly five or six months. Now, the question is, is the New York Stock Exchange and the NASD too concerned with the well being of their membership that they haven't bitten the bullet and come out with the kinds of rules that I think both of those self-regulating organizations should come out with -- and come out with promptly? ...

Tell me about "best practices."

The Securities Industry Association has responded to the enormous amount of adverse press that sell-side analysis has received in recent weeks and months. And my reaction to that is that's a step in the right direction, but only a step. "Best practices" are steps taken to really avoid draconian actions taken by regulators. I am suggesting: Be skeptical of best practices and what kind of teeth best practices apply.

The industry has a clear incentive to play to corporate clients. Best practices may diminish some of the most obvious conflicts of interest, but probably not much more than that. And I think we need more than best practices.

"Best practices" is a term that was coined by whom?

Oh, "best practices" is something that we have seen in business for years. A business or a group of businesses or an industry in responding to generally a specific public relations problem will come up with best practices that they expect their employees and their corporate leadership to embrace. But it's short of a mandate to act this way or that way to clear up a problem that I think is an ethical problem. We are talking about ethics here as much as anything else. And I am skeptical about the ultimate impact of a best practices solution. I think we need more than that.

Skeptical about the industry's ability to regulate itself without external mandates?

There is a place for self-regulation. And that's why I called on the NASD and the New York Stock Exchange to come up with specific directions with respect to the independence of the process of providing research.

I think that if they took hard-headed, direct and specific action, that would be far better than a best practices solution.

You sent SEC staff to talk to the financial media about disclosure. Can you recount that for us?

I asked members of our staff to meet with the financial media and urge upon them the discipline of getting their guests to identify the conflicts of interest that existed. I don't believe that it's the responsibility of the media to identify these conflicts.

I do believe it's the responsibility of the guests -- the so-called pundits, the analysts -- to very clearly identify when they are conflicted by either personal holdings or corporate responsibilities which fly in the face of the independence that they must manifest in terms of the public. ...

What was your attitude towards the media during this whole [period]? You talked a little bit about Madison Avenue and its role. But what about the financial media -- CNBC? CNNfn?

I think they are a vehicle. They are a conduit. And I don't believe any government agency can monitor and discipline the media in terms of content. I think they can set the stage for seeing to it that the people who appear on stage are forthcoming about their conflicts. I don't think they can do anything beyond that. ...

What was the response of the financial media to your talks?

Initially, the financial media had kind of an approach of economic Darwinism; individual investors should have the burden of responsibility in determining what was valid and what wasn't.

When we pointed out to them that, in some cases, the conflicts represented by reporters are blatant and really could hurt the whole area and would be disruptive to public confidence in our markets, they tended to be more sympathetic to placing the burden of responsibility on the individual guest, rather than on the media themselves. They viewed themselves as a conduit of information. Certainly they did not want to be held responsible for the independence of that information.

They felt, however, that when we pointed out to them that some of their reporters were really misleading the public by withholding information, I think they were generally supportive of our efforts to have rules put in place; not for them, but for the guests that appeared on their programs.

...

The networks, in general, felt that they had no responsibility in terms of monitoring the guests that appeared on their programs. And my feeling was that the analysts [who] came on those shows and promoted certain stocks that represented companies involving investment banking clients for their employers, had a responsibility to clearly reveal that on camera. I still feel that way. I still feel that the kind of exposure we're getting from analysts in both print and electronic media is incomplete and inadequate.

So is there a change today in what we view?

No, I don't believe so. Change has not come about through any rulemaking. The change that has come about is a function of the enormous amount of public attention that's been called to the lack of independence of much of the research that the public is receiving. That has some impact on quality of research, and we're seeing a number of sell reports that we might never have seen before.

But we will drift back into the same kinds of conflicts, in my judgement, unless rules are put in place by self-regulators, such as the New York Stock Exchange and the NASD, which would clearly lay out what represents a conflict on the part of sell-side analysis. Best practices is a step in that direction, but just a step. It is not enough, in my judgement.

The playing field, during your tenure, became more level through various efforts of the SEC. But the IPO frenzy proved there was a long way to go. What can you tell me about what was exposed by the IPO frenzy -- whatever you want to call it?

You speak of the IPO frenzy as some new element in America's financial landscape. It isn't. We've had IPO frenzies before, many of them. We've had bubbles before, many of them. The only difference here is that the length of this bull market has been of greater duration. And the longer a bull market runs, the less careful investors become, and the more likely they are to be taken in by IPOs of any kind.

At the beginning, IPOs are hard to do, and only the most solid of companies are able to raise public funds. By the end of the cycle, you could raise funds for any harebrained scheme and get away with it. You can raise funds for a company that hadn't earned any money and is unlikely to earn money in the future. So I don't think this IPO frenzy was significantly different, except in terms of the magnitude, than any other. ...

Well, the pressure to score hot allocations led mutual fund managers to make arrangements with investment banks that are now under SEC investigation.

I can't discuss with you matters that are under investigation by the commission.

In general, during the course of 42 investor town meetings that I conducted all over America, one of the questions asked most frequently by individual investors who felt they were being disadvantaged was, "Why can't I get hot issues? Why must I take a back seat to large customers and brokerage firms?"

My answer to them invariably was, "If you're basing investment decisions on buying new issues, you're making a mistake, and you're going to get burned. It's a dumb way to invest. Most investors who do that lose money."

Secondly, I said to them, "There's no reason why an investment firm shouldn't allocate new issues or hot issues, or whatever you wish to call them, to their best customers." That's a good business practice, in the same way that an automobile dealer will allocate the first new, highly desired car to a customer that had been with them for a period of time. I suggested to investors that if they want to play the new issue game, they should buy mutual funds that specialized in new issues. ...

You went around to town meetings. The most common question you got was, "Why can't I get in on an IPO?" ... It seems there's a disconnect here. On the one hand, we're being told the playing field is level. On the other hand, we can't get in on the best deals. ...

I guess what I disagree with is the notion that an individual has the right to get a new issue that is comparable to the right of the customer that may be a larger customer than that individual. Every individual has the right to say to their broker, "Mr. or Mrs. Broker, if you want my account, you must allocate to me a certain number of new issues." Again, I think it's a bad investment practice. But it's up to the firm to decide how they want to make their allocation, and making it on the basis of the size of the customer, I think, is an acceptable way of doing it. ...

If you say that the brokerage firms are hyping the wrong thing, I totally agree with you. But if you're taking it a step further and saying they have an absolute obligation to give the individual the new issues along with the institution, you're way off base.

...

There's been some complaining about the practice of VCs and entrepreneurs, management teams, board members, who cashed out tens of millions of dollars in new Internet companies just after the lock-ups expired -- when, at the same time, these stocks were being touted -- and abandoning, leaving the public in the lurch, when the public felt it was getting information that was telling it to buy. Should people be upset about that?

I can understand their being upset by that. If those practices in any way violate the security laws, there are remedies for that. I don't think those practices have violated the security laws. There were holding periods that would kick in at that point.

But I can understand investors feeling abused by this. Investor disillusionment, in my experience, is a function not of any one corporate action. It is a function of lots of little things generally kicking in at a time when the market goes down and the investor loses money. At that time, the investor looks at board structure, at board actions, at particular kinds of research -- a lot of factors -- and the investor then says, "You know, in some way I'm being duped. I'm being fooled."

I don't necessarily believe that the investor is right about all the elements of being fooled. But it doesn't matter. If the investor loses confidence as a result of lots and lots of these provocations, the investor will be slower to come back to our markets. And that, in my judgement, would represent an economic catastrophe.

So I think it's terribly important -- and I believe that most of the responsible business leaders that I know share the feeling -- that corporate America, their regulators, their legislators, do everything possible to see to it that investors have confidence in the system. ...

If you want to talk about all the elements of public disillusionment, you talk about analysis, you talk about order execution. Does the customer know that he could get a better execution if his order were being executed on the Philadelphia Stock Exchange instead of the Pacific Stock Exchange? You talk about compensation of brokers. Would the advisor/broker be recommending a given stock if he did not get a quantitative compensation for it, rather than a qualitative? Is he being paid more for this recommendation than another one? In terms of the kind of advertising that we've seen, when you hype pie-in-the-sky mansions and islands, how will the investor react in a down market? ...

When you see the misstatement of earnings by corporations, when you see accounting firms allowing misstated numbers and restatement of earnings that have caused values in stocks to drop by 25 percent to 30 percent and sometimes 50 percent -- all of these elements conspire to disillusion the public investor.

And all of these elements -- the broker, the brokerage firm, the auditor, the advertising agency, the underwriter -- all of these players in this financial scene have some measure of responsibility.

If it's in their interest to maintain an investing public, why do these things continue to happen?

In a kind of bubble environment, the excesses on all levels of the chain of raising capital are most manifest. It brings out the basest qualities of all the players; the kinds of guidelines that monitor corporate behavior tend to be more flexible at a time when there's excess, and it feeds upon itself.

The public is part of this process as well. They're not guiltless. The public simply lacks the kind of skeptical monitors that should always be part of the investing decision.

And the people that feed into that, in terms of the brokerage firms and the analysts and the mutual funds and others in the chain of distribution tend to be giving the customers what they believe the customers want. And they also tend to believe their own rhetoric. In a country which is fueled by fierce competition, if one online brokerage firm is selling islands or mansions, the other online brokerage firm can't be far behind. Their directors will be holding them accountable for being too stuffy.

But the firm, the advisor, the broker who thinks about the investor's interest in much more historic terms, much greater balance, is the one which will emerge with a sounder reputation and better standards and a quality image that will far outweigh the islands and the mansions and that kind of ridiculous hype that we've seen at the height of the market frenzy.

The rap on the SEC is that you're a posse of too few and with not enough strength, not enough muscle. Comment?

... I don't think any government agency has, or should have, enough resources to totally insulate investors against all fraud and misdeeds, and, most importantly, protect them from their own foolishness.

As I go through the Internet on a practically nightly basis, and as I review the enforcement cases that I saw at the SEC, I am constantly amazed at the inability of America's investors to equate risk and reward. And that becomes most obvious at a time of prolonged market rise. ...

I think the resources of the SEC could well be increased because of the proliferation of Internet fraud. But I think the basis, the premise, of investor protection in the United States -- which is the best by a long shot of any place in the world -- is a three-legged stool: the protection offered by the SEC's enforcement effort; the protection offered by the self-regulating organizations, the NASD and the New York Stock Exchange; and the protection offered by private rights of action, the ability of individuals to bring suit. Those three serve investors in very good stead in both good times and bad times.

...

[Getting back to the IPO allocations...] If an investor, a large mutual fund, is receiving an allocation in an IPO on the understanding that they will make certain purchases or pay higher commissions in the aftermarket, is that a serious violation?

Hypothetically, if that investor, that recipient of an IPO, was required to pay extraordinary commissions on non-related transactions or required to make specific aftermarket purchases, I believe that, hypothetically, you could consider that a manipulative action.

That manipulates the price of a stock.

It could.

It could manipulate the price of the stock. The intention is to manipulate the price of the stock.

Right.

I would assume that that's the intention -- to manipulate the price of a stock upwards, and then finally dump it to the public and all the insiders get out.

I wouldn't comment on that.

But I wouldn't be too far off base to guess that that would be the result?

It's a possibility on a hypothetical instance.

...

Were there particular instances of analysts going on television, that you can remember, where your blood boiled a little bit and you thought, "Man, we're really out of control here?"

I can't recall the specifics, but I've always felt that investing is a professional discipline. You are dealing with people's lives. And some of these practices representing advertising, representing analysts who treat this like a horse race, rather than a serious discipline, do a disservice to what should be a profession. I think that the hype, the feeding frenzy of recent years, played to investors' basest instincts, and that was unfair to the process and, I think, denigrating to the image of analysis, which should be very different than what we've seen.

How did we get to this point? It happened during your time, where so many individuals came to the market. That had not happened for some time.

That's very simple. If you tell me that ten years in the future we will have a 20-year bull market, I would be able to describe to you an absolute avalanche of investor interests coming into that market. If you told me that over the next year we would have a declining market, I would tell you that the amount of individual interest on the part of investors would fall by a dramatic amount. It's a function of the rise in the market.

And it's a function of increased communication, allocations of advertising dollars, which have been unparalleled in the history of financial services. This is all a predictable part of the process.

Did you ever go to the companies and complain about how they were spending their advertising dollars?

I often spoke to companies about that. I even spoke to self-regulating organizations -- the NASD, in particular -- about their sign in Times Square, the New York Stock Exchange about advertising that didn't teach the investor, but advertising which just competed against other marketplaces. I felt that that hurt the investor.

But again, it's not the job of the regulator to tell the companies how they should advertise. I was just expressing my personal view that they do themselves a disservice by lowering the threshold of professionalism in terms of their advertising.

What was their response?

They felt that I was exceeding my responsibilities as a regulator. And I told them that I was just giving vent to my own personal attitudes as someone who's been in the securities business for some period of time, and someone who has dealt with individual investors and heard a lot about it.

One could argue that your job as a government official is to protect the investors; it falls very much under your mandate.

I think all regulators have a bully pulpit, and some use it more than others. I made a speech before the National Press Club in Washington at the height of the online brokerage firms' advertising. And I made the point, which I hope got across nationally, that I felt the advertising that I was seeing was patronizing and demeaning, and not in either the short- or long-term interests of the firms that were promulgating that advertising.

I told them, right out front, I didn't intend to regulate their advertising -- and probably couldn't -- but that I would take every opportunity I could of humiliating them when I saw advertising that I felt was so outrageous. And from time to time, I did that.

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What is the role of the private litigators in pressuring the investment [banking community]?

I think that any system of public protection depends upon the ability of investors to bring their own litigation when they are wronged, when they are defrauded. The SEC has no criminal authority. They can impose sanctions. They can bar individuals from holding seats on public companies or from being in the brokerage business. But the ability of individuals to bring suit if they feel defrauded is a very important protection.

That litigation sometimes can be spurious. And I think it probably has. But the law with respect to litigation has changed, and the number of suits being brought has diminished considerably. ...

In 1995, Clinton vetoed the SEC Reform Act. What was your reaction?

I felt at that time that there were clearly abuses in terms of the number of irrelevant, costly suits that had been brought in recent years that really were destructive to the process.

I [also] felt that the number of recommendations made by corporate America and others representing that part of the business community were excessive. One, for instance, called for losers to pay the cost of litigation. I felt that was an extreme solution that would deprive poorer people from the ability to bring legal action to protect themselves. And the bill that was worked out as a result of consultations between the commission and the House and the Senate, I felt was an improvement over the bill that was created. ... So I think that the litigation reform worked as well as you can expect any legislated solution.

...

[You] don't take on an investigation unless you think it's signature in some way, that it's significant?

Right.

So let me just ask you. When the SEC decides to take on an investigation ... It can't investigate everything. So what leads you to investigate some things and not others?

If we believe that a given area represents a broad kind of fraud that may be impacting a substantial numbers of investors, that becomes a high priority for us. Obviously, we can't always tell when this is the case until we get into an investigation. But clearly some areas represent the kind of broad public danger that would motivate a signature investigation and ultimately a successful resolution.

So it's fair to say that when the SEC decides to investigate, with its limited resources, it has to be a major offense.

Well, we like to think of it in those terms. Not every investigation turns into a major offensive. Many investigations are closed without resolution. But in terms of time that we spend in a given area, we're going to devote our resources to those areas that we believe represent the greatest danger to the American public, like any law enforcement agency. ... The only way to do this is to look at a broad number of cases and then focus our activity on those that we believe are the most relevant. ... We open many more investigations than we resolve.

We've been told that some people in the investment banking community have come forward to the SEC and laid out their practices -- the laddering, excessive commissions. ... Will these allocation tie-ins, laddering, etc. -- is this something that is provable?

I can't comment on a specific investigation. But I can say to you that -- again, on a hypothetical basis -- this kind of allegation would be very difficult to prove; not impossible, but difficult. And that's so because you would have to have hard evidence of conversations, of transactions, of other elements of fraud. I think that's possible. But I don't think it's something that you can readily assume that the investigation will necessarily and certainly lead to a resolution.

And in some cases, the practices probably have been more blatant than others, and may not be as general as others. But I simply don't know. Nor can I comment, or would I comment, on a specific investigation.

But presumably you'll be relying on ... the SEC would be relying, hypothetically, on witnesses. Most of this isn't written down. ...

It's very difficult to describe how one case would differ from another. I think witnesses on tapes or electronic communications ... It could be a whole host of clues that could lead you to a conclusion.

...

We saw over and over again companies that had never shown a profit, where the executives and the board members had been able to cash out at enormous profit, then leave the company ... Something seems wrong here. ... What role does the SEC have as my watchdog on this whole process?

But the law is not being violated. You haven't described a violation of the securities laws.

What impact does that have? Is that not a concern?

I think that a company that engages in the practice of putting out an abundance of press releases, that uses or manipulates analysts to tell only the best side of their story, a company that tries to hype their stock in the marketplace ... while at the same time executives may be selling, is just hurting the role of corporate America, from a perceptual point of view.

And I think the really good executives in the good companies that I know of don't engage in that practice. It's foolish. It will ultimately hurt the company, because the market understands hype -- it really does. And over a period of time, corporate executives that engage in that practice pay a penalty for it in the long run.